What is a promissory note?

A promissory note is a written agreement between a lender and a borrower that sets out the terms of a loan.

Promissory notes are used in various situations, such as when someone borrows money from banks, credit unions, or individuals, finances a car or other significant purchases, takes out student loans, or when businesses borrow money from other businesses or banks.

In this article, we'll talk about what promissory notes are for, what's in them, and how the law sees them. This will help you understand this important document better.

What are the key components of a promissory note?

Most promissory notes have the same basic structure and include vital components, including:

1. Principal Amount:

• This refers to the initial amount of money borrowed by the borrower from the lender. It forms the basis for calculating interest and determining the total amount to be repaid.

2. Interest Rate:

• This is the annual percentage rate charged by the lender on the borrowed amount. It can be fixed (unchanging throughout the loan period) or variable (subject to change based on market conditions).
• The interest rate determines the cost of borrowing for the borrower and the return on investment for the lender.

3. Repayment Terms:

• This section outlines the frequency and duration of the payments made by the borrower to repay the loan. Common repayment terms include monthly, quarterly, or annual installments.
• The repayment terms impact the borrower's cash flow and the lender's ability to recoup the borrowed amount.

4. Due Dates:

• These are the specific dates on which each payment is due. Prompt payment on due dates is crucial to maintain good credit standing and avoid late fees or penalties.
• Due dates can be aligned with the borrower's income cycle to facilitate timely payments.

5. Maturity Date:

• This is the specific date on which the entire loan amount, including any remaining principal and accrued interest, becomes due and payable.
• The maturity date marks the end of the loan term and the full repayment of the debt.

6. Default Provisions:

• Default provisions outline the consequences faced by the borrower in case of failure to make timely payments or comply with other terms of the note.
• Common default provisions include late fees, increased interest rates, acceleration of the loan's maturity, and potential legal action by the lender.

7. Signatures:

• The promissory note must be signed by both the borrower and the lender to be legally valid. Signatures indicate the agreement of both parties to the terms and conditions of the loan.
• Without valid signatures, the promissory note may be unenforceable in a court of law.

What are the different types of promissory notes?

There are a number of different types of promissory notes, each with their own differences and use cases.

Unsecured promissory notes

• Do not require any form of collateral to guarantee the repayment of the loan.
• Rely solely on the borrower's credit history, financial stability, and personal guarantee.
• Often come with higher interest rates compared to secured notes due to the increased risk for the lender.
• Examples include personal loans, signature loans, and student loans without a cosigner.

Secured promissory notes

• Require the borrower to provide collateral, such as real estate, vehicles, or other valuable assets, as security for the loan.
• Provide the lender with the legal right to seize and sell the collateral if the borrower defaults on the loan.
• Typically have lower interest rates than unsecured notes due to the reduced risk for the lender.
• Examples include mortgages, auto loans, and secured lines of credit.

Demand promissory notes

• Give the lender the right to demand immediate repayment of the entire loan amount at any time.
• Often used for short-term loans, bridge loans, or when the lender wants flexibility in accessing the funds.
• May include a provision that allows the borrower to prepay the loan early without penalty.
• Examples include demand notes issued by banks and credit unions, and short-term business loans.

Term promissory notes

• Specify a fixed repayment period and schedule, including the due dates and amounts of each payment.
• Common for long-term loans such as mortgages, auto loans, and personal loans.
• May include provisions for early repayment with or without prepayment penalties.
• Examples include mortgage notes, auto loan contracts, and personal loan agreements.

Master promissory notes

• Used in situations where a borrower has multiple loans with the same lender, typically for educational purposes.
• Establish the overall terms and conditions that apply to all the loans under the master promissory note.
• Individual loan agreements may be created based on the master promissory note, detailing the specific loan amounts, interest rates, and repayment schedules for each loan.
• Examples include Federal Direct Loans and private student loans.

How do promissory notes work?

Promissory notes work as a written agreement between a lender and a borrower that outlines the terms of a loan. Here's a simplified explanation of how promissory notes operate:

Agreement and signing

The lender and borrower agree on the loan amount, interest rate, repayment terms, and other conditions. Both parties then sign the promissory note, making it a legally binding contract.

Loan disbursement

The lender disburses the loan amount to the borrower, typically through a bank transfer or check.

Repayment schedule

The borrower makes regular payments to the lender according to the agreed-upon repayment terms. These payments usually include a portion of the principal (borrowed amount) and the accrued interest.

Interest calculation

Interest is calculated on the outstanding loan balance, typically based on the annual percentage rate (APR) specified in the note. Interest payments are usually made along with the principal repayments.

Maturity date

The promissory note specifies a maturity date, which is the final due date for the entire loan balance. On or before the maturity date, the borrower must pay the remaining principal and any outstanding interest.

Default consequences

If the borrower fails to make timely payments or violates any terms of the promissory note, they may be considered in default. Consequences of default can include late fees, increased interest rates, acceleration of the loan's maturity, and potential legal action by the lender.

Collateral and security

Some promissory notes may be secured by collateral, such as real estate or vehicles, which serves as additional security for the lender. If the borrower defaults, the lender may have the right to seize and sell the collateral to recover the outstanding debt.

Promissory notes provide a structured framework for lending and borrowing, ensuring that both parties understand their rights and obligations throughout the loan period.

What are the legal implications of promissory notes

Promissory notes are legally binding contracts, and failure to comply with the terms can result in legal consequences for both the borrower and the lender.

For the borrower

• Default: Failure to make timely payments or comply with other terms of the note can lead to default. Consequences of default may include late fees, increased interest rates, acceleration of the loan's maturity, and potential legal action by the lender.
• Personal liability: In the case of an unsecured promissory note, the borrower's personal assets may be at risk if they default on the loan.
• Impact on credit score: Late payments and defaults can negatively impact the borrower's credit score, making it more difficult to obtain future loans and credit.

For the lender

• Breach of contract: If the borrower breaches the terms of the note, the lender may have the right to take legal action to enforce the contract and recover the outstanding amount.
• Secured notes: In the case of a secured promissory note, the lender may have the right to seize and sell the collateral if the borrower defaults on the loan.
• Statute of limitations: Lenders must initiate legal action to collect on a promissory note within the time frame specified by the statute of limitations in their jurisdiction.

General legal considerations

• Validity: To be legally valid, a promissory note must meet certain requirements, such as being in writing, signed by both parties, and containing essential elements like the principal amount, interest rate, and repayment terms.
• Enforceability: Promissory notes are generally enforceable in a court of law, provided they are valid and there is no evidence of fraud, duress, or undue influence.
• Negotiability: Some promissory notes may be considered negotiable instruments, allowing them to be transferred to a third party.

It's important for both borrowers and lenders to understand the legal implications of promissory notes before entering into such agreements. 

Consulting with an attorney can be beneficial to ensure that the note is drafted in accordance with applicable laws and to address any specific concerns or questions.

What are the common uses of promissory notes?

• Personal Loans: Promissory notes are frequently used for personal loans between friends, family members, or individuals. They outline the terms of the loan, including the amount borrowed, interest rate, repayment schedule, and any collateral involved.
• Real Estate Transactions: In real estate transactions, promissory notes are often used to finance the purchase of property. The buyer signs a promissory note promising to repay the loan amount plus interest to the lender, typically a bank or mortgage company.
• Student Loans: Promissory notes are commonly used in student loans. The student signs a promissory note agreeing to repay the loan amount, usually with interest, after graduation or dropping below half-time enrollment.
• Business Loans: Promissory notes are frequently used in business lending arrangements. They outline the terms of the loan, including the loan amount, interest rate, repayment schedule, and any collateral provided by the business.
• Equipment Financing: Promissory notes are often used to finance the purchase of equipment, such as machinery or vehicles, for businesses. The borrower agrees to repay the loan amount plus interest over a specified period.
• Invoice Financing: In invoice financing, a business may use a promissory note to secure a loan from a financing company based on the value of its outstanding invoices. The promissory note outlines the terms of the loan and the repayment schedule.
• Lines of Credit: Promissory notes can be used to establish lines of credit, where a borrower can access funds up to a specified limit and agrees to repay the borrowed amount plus interest over time.

Why understanding promissory notes is essential for your financial decisions

Promissory notes involve legal agreements that create obligations and confer rights for both borrowers and lenders. Understanding promissory notes is crucial for making informed borrowing decisions, avoiding default, negotiating favorable terms, protecting assets, estate planning, making investment decisions, and ensuring legal compliance. 

In addition, promissory notes serve as legally binding contracts, empowering individuals to manage their financial responsibilities proactively and safeguard their interests. For more expert tips and advice on credit management, take a look at the Chaser blog. Or, to ensure your business receives promised payments on time, speak to an expert about how Chaser's software can support you.